Why Invest in Index Funds?

Pay less for a product or service, and you’ll have more money left over afterwards. Pretty straightforward, right? For some reason, many investors seem to think that this rule doesn’t apply to the field of investing. Big mistake.

Index Funds 101

A bit of background: Most mutual funds are run by people picking stocks or other investments that they think will earn above-average returns. Index funds, however, are passively managed. That is, they seek only to match (rather than beat) the performance of a given index.

For example, index funds could be used to track the performance of:

The entire U.S. stock market,

Certain sectors of the U.S. stock market (the pharmaceutical industry, for instance),

Various international stock markets,

The bond market of a given country, or

Just about anything else you can think of.

Most Actively Managed Funds Lose.

The goal of most actively managed funds is to earn a return greater than that of their respective indexes. For example, many actively managed U.S. stock funds seek to outperform the return of the U.S. stock market. After all, if an active fund doesn’t beat its index, then its investors would have been better off in an index fund that simply tracks the market’s return.

Interestingly, most investors actually would be better off in index funds. Why? Because — due to the high costs of active management — the majority of actively managed funds fail to outperform their respective indexes. In fact, according to a study done by Standard and Poors, for the five-year period ending 6/30/2014:

Less than 27% of U.S. stock funds managed to outperform their respective indexes,

Less than 30% of international stock funds managed to outperform their respective indexes, and

Less than 40% of taxable bond funds managed to outperform their respective indexes.

Now, lest you think that this particular period was an anomaly, let me assure you: It wasn’t. Standard and Poors has been doing this study since 2002, and each of the studies has shown very similar results. On average, actively managed funds have failed in both up markets and down markets. They’ve failed in both domestic markets and international markets. And they’ve failed in both stock markets and bond markets.

Why Index Funds Win

The investments included in a given index are generally published openly, thereby making it easy for an index fund to track its respective index. (All the fund has to do is buy all of the stocks — or other investments — that are included in the index.) As you can imagine, implementing such a strategy can be done at a far lower cost than that charged by the average actively managed fund.

Common sense (and first grade arithmetic) tells us that:

If the entire stock market earns, say, a 9% annual return over a given decade, and

The average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.5%,

…then the average dollar invested in the stock market over that year must have earned a net return of 7.5%.

Now, what if you had invested in an index fund that sought only to match the market’s return, while incurring minimal expenses of, say, 0.2%? You would have earned a return of 8.8%, and you would have come out ahead of most other investors.

It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) refers to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Why Not Pick a Hot Fund?

Naturally, many investors are inclined to ask, “Why not invest in an actively managed fund that does beat its index?” In short: because it’s hard — far harder than most would guess — to predict ahead of time which actively managed funds will be the top performers.

Study after study has shown that past performance is not a helpful tool for picking the top performing funds and that your best bet for finding top-performing funds is simply to choose the lowest-cost fund in each asset class (e.g., domestic stocks, international stocks, etc.). This leads to the selection of index funds as the most likely top performers.

Taxes Are Costs Too.

If you’re investing in a taxable account (as opposed to a 401(k) or IRA), index funds can help you not only to minimize costs, but to minimize taxes as well. With mutual funds, you pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

Because most active fund managers buy and sell investments so rapidly, a large percentage of the gains end up being short-term capital gains. Because short-term capital gains are taxed at your ordinary income tax rate (as opposed to long-term capital gains, which are currently taxed at a maximum rate of 20%), you’ll end up paying more taxes with actively managed funds than you would with index funds, which typically hold their investments for longer periods of time.

Not All Index Funds Are Low-Cost.

Do not, however, invest in a fund simply because it’s an index fund. Some index funds actually charge expense ratios that are close to — or sometimes even above — those charged by actively managed funds. It’s a good idea to take the time to check a fund’s expense ratio and compare it to the expense ratios of other funds in the same category before investing in it.

Alternatively, if you don’t want to take the time to check, Vanguard’s index funds are generally a good way to go. In most asset classes, if Vanguard isn’t the single lowest cost provider, they’re very close.

When Index Funds Aren’t an Option

Unfortunately, in many investors’ primary retirement account — their 401(k) or 403(b) — they don’t have the option to select any low-cost index funds. If you find yourself in such a situation, my strategy for picking funds would be as follows:

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